Risk and Liquidity

12 Key excerpts on "Risk and Liquidity"

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  eBook - PDF

  Understanding Risk

  The Theory and Practice of Financial Risk Management

  • David Murphy(Author)
  • 2008(Publication Date)
  • Chapman and Hall/CRC

    (Publisher)

  These demands might be either expected , as in a coupon that we know we have to pay on an issued security, or unexpected , as in the early exercise of an option. * For a wider and more comprehensive discussion of liquidity risk, see Avinash Persuad’s Liquidity Black Holes: Understanding, Managing and Quantifying Liquidity Risk or Erik Bank’s Liquidity Risk . 338 ■ Understanding Risk: The Theory and Practice of Financial Risk Management 9.1.1 What Is Liquidity Risk? Liquidity risk , therefore, is the risk that a firm may not be able to meet its commitments when they become due at a reasonable cost. Consider the bank from the last chapter funding its loan portfolio with a mixture of deposits and interbank borrowing. The bank funds itself this way to enhance its NII but, in doing so, it takes interest rate Risk and Liquidity risk. To see this, suppose that one of the bank’s largest counterparties defaults and, as a result, rumours arise questioning the solvency of the bank. It might then have diffi culty in rolling its interbank borrowing: professional counterparties will not want to lend to it any more. There are then a few alternatives: The bank can raise funds in the secured market, perhaps by repoing its securities. It could try to attract more retail deposits. Alternatively, if both of these fail, it might have to sell its securities to raise enough funds to meet its expenses. At this point, it is a forced seller, and the liquidation prices obtained for the assets could be fairly far from the bank’s mark-to-market prices for them. Notice that the bank is not insolvent or even necessarily anywhere close to insolvency; it is just that the rumour that it might be is interfering with its ability to borrow in the interbank market. If the rumours become widespread, they might affect retail deposits, and the bank’s problems worsen. Liquidity risk arises in any situation where assets and liabilities are not completely matched.

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  Financial Enterprise Risk Management

  • Paul Sweeting(Author)
  • 2011(Publication Date)
  • Cambridge University Press

    (Publisher)

  An important point to note is that credit risk is very similar to non-life insur- ance risk in that there is both incidence (the probability of default) and intensity (the recovery rate). This is important to bear in mind when considering the techniques used in each to model and manage risk. 96 Definitions of risk 7.6 Liquidity risk Liquidity risk is a risk faced by all financial institutions. Illiquidity can man- ifest itself through high trading costs, a necessity to accept a substantially reduced price for a quick sale, or the inability to sell at all in a short time scale. This risk, that a firm cannot easily trade due to a lack of market depth or to market disruption is known as market liquidity risk. However, another aspect of liquidity is the ability of organisations to raise additional finance when required. The risk that a firm cannot meet expected and unexpected current and future cash flows and collateral needs is known as funding liquidity risk. When assessing the level of liquidity needed from the asset point of view, the timing and the amount of payments together with the uncertainty relating to these factors are key. However, some illiquidity can actually be desirable – if an institution can cope with a lack of marketability in a proportion of its assets, then it might be able to benefit from any premium payable for that illiquidity. However, it must be borne in mind that some illiquid assets also have other issues such as higher transaction costs or greater heterogeneity (real estate and private equity being key examples). Illiquid assets are also less likely to be eligible to count (or at least count fully) towards the regulatory capital of a bank or insurance company. Assets can provide liquidity in three ways: through sale for cash, through use as collateral and through maturity or periodic payments (such as dividends or coupons).

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  The Liquidity Risk Management Guide

  From Policy to Pitfalls

  • Gudni Adalsteinsson(Author)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  In a nutshell, all funds coming into a bank belong to one of the three above-mentioned categories and only through them can a bank increase its liquidity position. As cash coming in from the businesses (money coming in from repayments) is not really manageable in the short or medium term, liquidity management is mainly focused on the other two, that is how to manage the borrowings and create liquidity with assets.

  4.1.2 Liquidity Risk

  Having better understood the term liquidity we move to defining liquidity risk. Again, Figure 4.1 can help. Liquidity risk can be explained diagrammatically as the risk related to the previously mentioned inflows and outflows.

  A bank can have sources of new liquidity dry up; for instance the bank may not be able to issue new bonds or a lesser amount of new deposits are placed with the bank. On the outflow tap the risk could develop when higher than expected loan growth occurs or higher amounts of deposits are withdrawn than expected. Note that the cash flow risk can come from both sides of the balance sheet. Liquidity risk is therefore not only a function of liabilities but assets as well.

  When attempting to formalize the definition of liquidity risk, we again find ourselves in a universe of limited standards, but the most common definition of liquidity risk is: Liquidity risk is the inability to meet obligations as they become due and payable. This we can agree is the primary and most rudimentary definition of liquidity risk, that is the risk of default and insolvency. Some authors have expanded on the definition by adding in the currency required at the end of the definition and even pointing out the market risk element by adding expected and unexpected obligations. Both of these additions are examples of certain specific sources or types of liquidity risk but as there are many other types of liquidity risk, this book does not attempt to incorporate them into the general definition of liquidity risk. Then there are others who define liquidity risk as the inability to meet obligations as they become due and payable or only being able to do so at an unsustainable cost.

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  Practical Risk Management

  An Executive Guide to Avoiding Surprises and Losses

  • Erik Banks, Richard Dunn(Authors)
  • 2004(Publication Date)
  • Wiley

    (Publisher)

  It should be clear from the brief discussion above that a firm can face a large universe of risks! These risks can change as markets, products, regulations and competitors change and evolve. As such, defining the nature of risk must be a dynamic process. It is imperative for a firm to continuously review its operations and make sure that it has identified all sources of risk – and that management shares a common understanding of these risks. Formalizing this through regular annual reviews is a good discipline. 3 Liquidity: The Heart of the Matter In our experience liquidity risk is a critical, but often overlooked, area of risk. Mismanagement of liquidity risk can lead to severe financial losses and, in extreme situations, even bankruptcy. Indeed, loss of liquidity – rather than a loss in risk taking that might spark a liquidity crisis – has ultimately been the reason for most bankruptcies or liquidations in the financial industry. The term liquidity risk has been a lot more prominent since the collapse of LTCM. It seems, however, to be used with different meanings – depending on the context – and needs to be better defined. In this chapter we propose a definition centered on asset and funding liquidity risks – as well as the effects of combined asset/funding problems – and discuss mechanisms for monitoring and controlling such risks. Figure 3.1 highlights these broad categories of liquidity risk. 3.1 ASSET LIQUIDITY RISK In Chapter 2 we defined asset liquidity risk as the risk of loss due to an inability to realize an expected value on a position when needed. A firm might have to sell assets to meet payments, make an alternative investment in financial instruments or plant and equipment, repay maturing debt, or comply with regulatory or corporate directives. If it cannot then sell an asset at its carrying value, it faces the risk of loss.

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  Financial Enterprise Risk Management

  • Paul Sweeting(Author)
  • 2017(Publication Date)
  • Cambridge University Press

    (Publisher)

  7.6 Liquidity Risk Liquidity risk is a risk faced by all financial institutions. Illiquidity can manifest itself through high trading costs, a need to accept a substantially reduced price for a quick sale, or the inability to sell at all in a short time scale. This risk, that a firm cannot easily trade due to a lack of market depth or to market disruption, is known as market liquidity risk. However, another aspect of liquidity is the ability of organisations to raise ad- ditional finance when required. The risk that a firm cannot meet expected and un- expected current and future cash flow and collateral needs is known as funding liquidity risk. When assessing the level of liquidity needed from the asset point of view, the timing and the amount of payments together with the uncertainty relating to these factors are key. However, some illiquidity can actually be desirable – if an insti- tution can cope with a lack of marketability in a proportion of its assets, then it might be able to benefit from any premium payable for that illiquidity. Having said this, it must be borne in mind that some illiquid assets also have other issues such as higher transaction costs or greater heterogeneity (real estate and private equity being key examples). Illiquid assets are also less likely to be eligible to count (or at least count fully) towards the regulatory capital of a bank or insurance company. Assets can provide liquidity in three ways: through sale for cash; through use as collateral; and through maturity or periodic payments (such as dividends or coupons). From the funding point of view, it might sometimes seem attractive to lend over the long term whilst using short-term funding – for example, selling mortgages whilst raising capital in the money markets. This will appeal particularly when long term interest rates are higher than short term rates.

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  Managing Banking Risks

  • Eddie Cade(Author)
  • 1997(Publication Date)
  • Woodhead Publishing

    (Publisher)

  The immediate focus is essentially short term because, as assets and liabilities run off and are replaced, the pattern of the bank's more distant cash flow engagements will be reconstituted many times over before their settlement time draws near. 56 risk has its sources on both sides of the balance sheet, and that management of the risk has to address normal as well as stressed conditions. Liquidity risk, the potential for running short of cash in hand to settle debts and commitments when due, has some kinship with solvency risk (Chapter 3). Both are crystallised in an inability to meet financial obligations in full; but illiquidity is temporary, and insolvency permanent. Insolvency in a normally capitalised bank is the direct consequence of massive losses, whereas illiquidity is not necessarily associated with losses or writedowns but results from incoming and outgoing cash flow relationships. However, failure to control liquidity risk adequately can, uncomfortably quickly, turn a temporary difficulty into a permanent one. Liquidity risk may also be seen as something of an obverse or reciprocal of credit risk (Chapter 5). My liquidity problem may cause me to be unable to pay you: that is your credit risk as my creditor. My default may precipitate your liquidity shortage which prevents you from paying your creditors, who may then have difficulty paying theirs . . . . The potential for such a bilateral or multilateral chain reaction of alternate credit and liquidity failures is known as systemic risk, which we shall come to in a later section. In one sense or another, it is true to say that liquidity is bought at a cost and is thereby intimately bound up with interest rate risk (Chapter 8). Some analysts take this logic to the extreme of classifying liquidity risk as a branch of interest rate risk.

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  Encyclopedia of Financial Models

  • Frank J. Fabozzi(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  The obvious alternative to probabilistic approaches to the estimation of crisis-liquidity is to use crisis-scenario analyses. We would imagine a big liquidity event—a major market crash, the default of a major financial institution or government, the outbreak of a war, or whatever—and work through the ramifications for the liquidity of the institution concerned. One attraction of scenario analysis in this context is that we can work through scenarios in as much detail as we wish, and so take proper account of complicated interactions such as those mentioned in the last paragraph. This is harder to do using probabilistic approaches, which are by definition unable to focus on any specific scenarios. However, as with all scenario analyses, the results of these exercises are highly subjective, and the value of the results is critically dependent on the quality of the assumptions made.

  KEY POINTS

  • Liquidity refers to the ability to execute a trade or liquidate a position with little or no cost or inconvenience.
  • Liquidity is a function of the market and depends on the type of position traded and sometimes the size and trading strategy of an individual trader.
  • Liquidity risks are those associated with the prospect of imperfect of imperfect market liquidity, and can relate to risk of loss or risk to cash flows.
  • There are two main aspects to liquidity risk measurement: the measurement of liquidity-adjusted measures of market risk (e.g., liquidity-adjusted value-at-risk, LVaR) and the measurement of liquidity risks per se (e.g., liquidity-at-risk, LaR).
  • There are a number of easily implementable and often complementary approaches to the estimation of liquidity-adjusted measures of market risk: the constant spread, exogenous spread, and endogenous price approaches , and the liquidity discount approach.
  • These approaches can produce risk estimates that differ substantially from the risk estimates obtained if liquidity is ignored.
  • There are a number of approaches to the estimation of liquidity risks in noncrisis situations. These include both LaR approaches and scenario analyses.

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  Managing Banking Risks

  Reducing Uncertainty to Improve Bank Performance

  • Eddie Cade(Author)
  • 2013(Publication Date)
  • Routledge

    (Publisher)

  Chapter Four Liquidity risk Banks must be capable of meeting their obligations when they fall due. Such obligations mainly comprise deposits at sight or short notice, term deposits and commitments to lend, including unutilised overdraft facilities. The mix of these obligations and their incidence in any period of time will vary between banks, but the maintenance of an assured capacity to meet them is an essential principle of banking which is common to all. The Management of Liquidity', Bank of England, July 1982 This chapter discusses: Liquidity management and regulation. Systemic risk. The impact of derivatives on systemic risk. The process of asset and liability management. 'Liquidity' is a term used by different bankers in different ways. Traders have in mind market depth and the relative ease or difficulty with which they can encash/liquefy/liquidate their positions. Other observers speak of liquidity risk as applying to nothing less than a tidal run on deposits, caused by loss of market confidence in the bank; in other words, as an extreme symptom of some other problem rather than a risk that can exist in its own right. Bank treasurers have to take a more comprehensive view: that liquidity risk has its sources on both sides of the balance sheet, and that management of the risk has to address normal as well as stressed conditions. Liquidity risk, the potential for running short of cash in hand to settle debts and commitments when due, has some kinship with solvency risk (Chapter 3). Both are crystallised in an inability to meet financial obligations in full; but illiquidity is temporary, and insolvency permanent. Insolvency in a normally capitalised bank is the direct consequence of massive losses, whereas illiquidity is not necessarily associated with losses or writedowns but results from incoming and outgoing cash flow relationships

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  Liquidity Management

  A Funding Risk Handbook

  • Aldo Soprano(Author)
  • 2015(Publication Date)
  • Wiley

    (Publisher)

  CHAPTER 4 Liquidity Value At Risk

  This fourth chapter deals with a matter requiring a dedicated book, separate from funding liquidity risk, and it is for this reason the shortest. For completion, a brief insight on the separate topic of liquidity risk, the value of risk modelling considering liquidity effects in the prices of securities, has been included. The first section introduces models and estimations for security liquidation timelines in market risk measures. The second presents the market liquidity adjusted risk modelling approach to adjust for various securities' different levels of liquidity.

  4.1 MARKET LIQUIDITY EFFECTS

  In the context of market risk, liquidity is the risk resulting from being unable to dispose of securities and positions at a reasonable cost and in due length of time, these being the trade-off costs of the immediate disposal and the risk of keeping the position. The costs will largely depend on the size of the position compared to the normal market size of the transaction and security type, these varying from extremely liquid to the opposite extreme.

  4.1.1 Market volatility

  The price volatility measured from the opening time to the closing is typically significantly higher than the volatility taken from one closing to the next.

  Infrequently traded stocks are characterized by large bid-ask spreads, conversely extremely liquid bonds, such as US Treasuries, are traded in small size and thin bid-ask ranges. The breadth of the spread depends on market supply and demand size for any specific security at a precise time: it varies depending on the securities, on the demand and supply at the time of quotation and on the markets' appetite for specific types of security. The type of order and its execution will drive the bid-ask spread. We can list different types of market orders:

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  Handbook of Analytical Studies in Islamic Finance and Economics

  • Zamir Iqbal, Tarik Akin, Nabil El Maghrebi, Abbas Mirakhor, Zamir Iqbal, Tarik Akin, Nabil El Maghrebi, Abbas Mirakhor, Zamir Iqbal, Tarik Akin, Nabil Maghrebi, Abbas Mirakhor(Authors)
  • 2020(Publication Date)
  • De Gruyter Oldenbourg

    (Publisher)

  Muhammed Habib Dolgun Chapter 17: Analytical Assessment of Liquidity Risk Management in Islamic Banks 1 Introduction Liquidity risk can be defined as a shortcoming to cover current financial liabilities. In general, liquidity risk is considered as a determinant of other risks, such as credit risk or determinant of bank performance (Arif and Anees 2012). An examination of the liquidity risk management in an Islamic banking context is crucial to promoting efficiency, growth, and resilience of the Islamic financial industry. While the resil-ience of the Islamic banking system during the recent Global Financial Crisis high-lights its potential contributive role to financial stability, particularly in countries with significant presence of Islamic banks, there remain several concerns. After the 2008 crisis, the global liquidity has been increased by central banks. The central banks injected considerable amount of liquidity and enlarged their reserves several times. For instance, the balance sheet of the Federal Reserve of USA exceeded over 4 trillion US dollars in 2013. Many emerging countries have enjoyed similar levels of liquidity. Islamic banks also have relished much of this liquidity abundance. Since Islamic banks had a more robust mechanism compared to their conventional coun-terparts, this liquidity helped them to increase the size of their assets. However, global liquidity is pulling back and central banks including Federal Reserve have already started their normalization period. In this new global liquidity environ-ment, Islamic banks may experience serious liquidity problems in foreign curren-cies in a lower liquidity environment. Furthermore, the Islamic financial markets in many countries are in their infancy stage. Accordingly, they may not be able to withstand the challenges and risks stemming from adverse systemic disturbances and financial shocks.

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  Managing Financial and Corporate Distress

  Lessons from Asia

  • Charles Adams, Robert E. Litan, Michael Pomerleano, Charles Adams, Robert E. Litan, Michael Pomerleano(Authors)
  • 2010(Publication Date)
  • Brookings Institution Press

    (Publisher)

  LIQUIDITY RISK INTERACTIONS. A particularly important challenge is to integrate liquidity considerations into calculations of market risk and potential credit exposure. Illiquidity can be factored into market risk VAR by estimating potential losses over a period sufficiently long to permit li-quidation of an asset position without a large price impact. Thus the stan-dard regulatory measure of market risk—3 times 99 percent per two-week VAR—implicitly provides capital to cover market risk over a position-unwind period much longer than the one-day horizon commonly used as a benchmark when VAR is used in applications other than capital ade-quacy calculations. A more differentiated approach now being imple-mented at a number of institutions assigns differing VAR time horizons, representing varied unwind periods, to asset classes depending on their li-quidity. Finally, one can also capture liquidity in VAR by modeling the bid-offer spread by asset class as a function of position size. Similar ap-proaches can be used to include liquidity effects in calculations of poten-tial credit exposure. In addition, stress testing can be used to examine the potential impact of liquidity shocks that have never (or only rarely) been observed and that may therefore be difficult to integrate into a VAR frame-work. (Aspects of liquidity risk are explored in more detail below.) FUNDING LIQUIDITY. One of the most important inputs to risk man-agement for a financial firm is an assessment of the sources and uses of funding liquidity for a period of at least one year going forward. 4 A con-servative analysis can be based on the assumption that in a crisis a firm would be unable to engage in any new unsecured borrowing, and that to avoid bankruptcy, cash outflows (for example, interest and principal pay-ments) would be satisfied on contracted terms.

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  Asset and Liability Management Handbook

  • G. Mitra, K. Schwaiger, G. Mitra, K. Schwaiger(Authors)
  • 2011(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Figure 2.4 shows the graphical profile of the numbers in Table 2.1. 2.2.2 Liquidity risk Liquidity risk exposure arises from normal banking operations. That is, it exists irrespective of the type of funding gap, be it excess assets over liabilities for any particular time bucket or an excess of liabilities over assets. That is, there is a Total USCP/ECP proceeds −2500 −2000 −1500 −1000 −500 0 o/n o/n–1 week 1 week–1m 1m–3m 3m–6m 6m–12m Bank Asset-Liability and Liquidity Risk Management 21 funding risk in any case; either funds must be obtained or surplus assets laid off. The liquidity risk in itself generates interest-rate risk, due to the uncer- tainty of future interest rates. This can be managed through hedging. If assets are floating rate, there is less concern over interest-rate risk because of the nature of the interest-rate reset. This also applies to floating-rate liabilities, but only insofar that these match floating-rate assets. Floating-rate liabilities issued to fund fixed-rate assets create forward risk exposure to rising interest rates. Note that even if both assets and liabilities are floating-rate, they can still generate interest-rate risk. For example, if assets pay six-month Libor and liabilities pay three-month Libor, there is an interest-rate spread risk between the two terms. Such an arrangement has eliminated liquidity risk, but not interest-rate spread risk. Liquidity risk can be managed by matching assets and liabilities, or by setting a series of rolling term loans to fund a long-dated asset. Generally, however, banks will have a particular view of future market conditions, and manage the ALM book in line with this view. This would leave in place a certain level of liquidity risk.

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